- Price (P) ↓ = Deflation ⇒ Expected Loss ↑ ⇒ Investment ↓, Employment ↓, Income ↓, AD ↓, Investment ↓ < Recession ⇒ Ultimately depression
- Price (P) ↑ = Inflation ⇒ Expected Profit ↑ ⇒ Investment↑, Employment↑, Income ↑, AD↑
There are various theoretical and empirical studies that have shown that inflation is not always harmful to the economy and society. If inflation is moderate or within a specific threshold, it creates positive effects in the economy, but if inflation exceeds a certain threshhold which is consistent with the overall goal of the economy, then it has negative implication to the economy.
So, inflation may have both positive and negative consequences, where the economy benefits from inflation if it is within a limit.
Effects of Inflation in the Economy
Positive Effect of Inflation
If inflation is moderate or within a threshold, it has a positive effect on the economy.
- Increased expected profit and encousage investment.
- Creates more employment opportunities.
- Supports for better utilization of resources.
- Improves the supply capacity of the economy.
- Supports for higher economic growth.
This means a moderate inflation is desirable to the economy in order to make it more vibrant and dynamic. However, if inflation is higher than a certain threshold, then it creates negative consequences in the economy and society.
Negative Effect of Inflation
- Economic effects/costs
- Favours the distribution of income and resources of the rich with multiple sources of income and increases the gap between the rich and the poor.
- Harms to the low and fixed-income earners.
- Increases the production and consumption of luxurious products, and more resources are diverted towards the same.
- Unfavorable to foreign trade, which increases imports and reduces exports, which harms the trade balance.
- Depreciate the value of the domestic currency and increase the import price, leading to a fall in the foreign exchange reserve.
- Political effects/costs
- Erosion/weaken the pubic trust in the government
- Opponents are becoming relatively stronger with the public agenda of inflation.
- Increases the political conflicts, uncertainty, and unrest in society.
- Discourages investment, employment, and growth due to political risk and uncertainty.
- Social effects/costs
- Increases the gap between rich and poor, including other social inequalities.
- Disturbs the social harmony and cohesion.
- Increases social crimes, social conflicts, and uncertainty.
- Discourages investment, employment, and growth due to threats to life and prosperity because of the increasing crimes.
- Psychological and moral effects/costs
- Increases frustration and depression among the common people with low and fixed incomes, and reduces labor productivity.
- Increases immoral activities such as stealing, cheating, human trafficking, etc.
- Increase the threat to life and property due to increasing crimes.
- Discourage investment, employment, and growth due to increasing insecurity in property and life.
- Other effects/costs
- Menu cost of inflation: during hyper-inflation, the prices are changed so rapidly that the firms have to adjust their menu accordingly, and it is costly to the firm and business.
- Shoe-leather cost on inflation: during the hyper inflation, the purchasing power of money declines so rapidly that people have to make frequent visits to banks and money lenders to manage cash for day to day transaction, and it has a huge opportunity cost due to long standing que and frequent visits.
Measures to Control Inflation
If inflation exceeds a certain threshold, specified by the policymaker based on the structure and the capacity of the economy, then it should be controlled to stabilize the economy.
There are fiscal and monetary policy measures for inflation control, which are:
1. Anti-inflationary Fiscal Policy/Measures:
The policy used by the government to control inflation are anti-inflationary fiscal policy, andthe following are the fiscal instruments:
- Decrease government expenditure.
- Increase tax to reduce consumption and investment.
- Increase in domestic borrowing by issuing new bonds and bills.
- Postponement of domestic debt retailing.
- Reduction in the external borrowing.
- Fix the price ceiling for the basic or necessary products.
- Quantity control or quota of the basic and necessary products.
- Encourage imports of basic and necessary products by providing subsidies and tax concessions.
- Restriction of the exports of basic and necessary products if there is a shortage in the domestic market.
- Promote public awareness of the value of money and discourage unnecessary consumption expenditure.
- Regular and effective regulation of the market to control artificial shortage and price hike, including cartels and syndicates.
2. Anti-Inflationary Monetary Policy/Measures
The policy designed and executed by the central bank to control inflation through the control of money and credit supply in the economy is an anti-inflationary monetary policy.
To control inflation, the central bank can use the following monetary instruments:
- Increase in CRR, SLR, Bank Rate
- Sell the financial securities to the market through open market operations such as Repo, Reverse Repo, and outright sales.
- Deposit auction from the market.
- Control of margin lending.
- Control of credit volume or rationing.
- Control of the higher purchase system.
- Provide monetary incentives for the import of basic necessary products.
- Discourage exports of basic and necessary products by reducing export credit or increasing the interest rate for such credit.
- Promote public awareness to reduce unnecessary expenses through appropriate media.
Other notes: